A Glimpse of Markets as we See Them Today

Quarterly Letter

Following an abysmal 4th quarter of 2018, equity markets rebounded with the biggest quarterly gain since the third quarter of 2009 and the best first quarter since 1998. As we have been emphasizing over and over, equity markets manage to sustain a valuation level (i.e. price/earnings ratio) that seems high relative to the last 40 years. The main reason is the decline of interest rates: they were around 20% back in the early 80s. Those of you who were making mortgage payments then surely remember. Today, rates are around 2%.

A simplistic example would explain this phenomenon:

  • If you own a perpetual bond that paid you $20 annually and the interest rate environment is 20%, that bond would be worth $100.
  • Suppose that today, the interest rate has fallen to 2%, that same piece of paper would be worth $1,000 ($20 divided by 2%).
  • Using a Price/Earnings valuation metric, under the 20% interest rate environment, the bond would have a P/E of 5 ($100/$20). However, if the interest rate is 2%, the P/E would be 50 ($1,000/$20).

Since equities are basically perpetual bonds with variable income (in the form of dividends), their valuation follows the same principle, therefore they are higher today than 40 years ago.

As long as rates stay at these levels, equity markets are neither cheap nor expensive overall. However, some sectors attract more investors/speculators, making them volatile and probably expensive while others are steady and stable making them cheap.
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Recent events affecting SNC-Lavalin and its corruption case prompt us to make some comments regarding our thinking behind this investment.

We believe that the treatment of SNC-Lavalin by some politicians on both sides of the aisle is missing the point: it is naive, preposterous, and even hypocritical to ask Canadian business people to abide by Canadian laws when the government encourages them to bid for business abroad, especially in countries where commercial customs are different and sometimes even illegal in Canada.

Canadian companies need to compete worldwide with many international companies and we cannot expect them to do so with one hand tied behind their back. It would be twice as naive to believe that other international companies do not resort to the same local business practices to gain business. However, countries around the world have made a tool available within their legal systems that acts to protect the innocent stakeholders of companies from the criminal actions of a few bad actors - it is called a “Deferred Prosecution Agreement”. A “Deferred Prosecution Agreement”, very similar to a non-prosecution agreement, is a voluntary alternative to adjudication in which a prosecutor agrees to grant amnesty in exchange for the defendant agreeing to fulfil certain requirements. Along with countries such as the USA, France, Germany and other developed ones, Canada also has such a legal process and this is precisely the circumstances for which it was designed.

Executives have been rightfully fired, some indicted. New management spent the last 2 years changing the leadership and removing those who were responsible for the issues that have damaged the firm and its reputation. We think it is time to settle the matter. If the Justice minister feels it is not enough, a financial settlement would be more appropriate instead of inflicting damage on the innocent: employees, suppliers, shareholders and other stakeholders. If SNC faces a criminal prosecution and conviction, it will be barred from bidding on Federal Government infrastructure contracts for the next 10 years – while foreign companies who have benefited by the Deferred Prosecution process in their own jurisdictions, having committed the same or similar infractions elsewhere, will still be allowed to bid on our Canadian major infrastructure contracts. We need to have our Canadian companies playing on an even playing field.
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The popularity of some Initial Public Offerings (the likes of Lightspeed in Quebec, Lyft in the USA and others) has awakened the greed in some investors who actually just do not know they are speculators. As Mark Twain said it so eloquently: “a mine is a hole in the ground and a liar on top”. In other words, it is about promoting, selling, pitching. It is about awakening the greed in people.

A recent study reveals that start-up investors/speculators (especially the unicorn chasers) expect the entrepreneurs of start-ups to lie. There is a fine line between lies and sales pitches. They also do not expect these young companies to make a profit. They are betting on an overvaluation to attract new rounds of private financing, double up and triple up their investments and then to get out on a sell-out or an IPO. The successive financing rounds are what make the investors at the top of the pyramid very rich, not the creation of a product or service. As for the rest, it depends.

This study is inspired by the resounding bankruptcy of Theranos, a start-up that pretended to be able to run multiple tests on one drop of blood. Its founder, Elizabeth Holmes, became one of the youngest self-made billionaires. Theranos managed to achieve 10 rounds of financing for a total of USD 1.4 billion without producing anything substantial.

How can it be that Theranos managed to go through 10 rounds of due diligence, one for each new round of financing, without anyone noticing that it does not make anything? The only answer is that the investors/promoters/speculators knew but did not care. They were not looking at a company that would beat its competitors with a better product. They were looking for one that could oversell its story. This is otherwise known as “The Greater Fool Theory”.

Despite the resounding truth in Mark Twain’s quote, why is it that “investors” continue to pile money into mining ventures? We guess it is the greed and the fear of missing out in humans that keep the industry going. Oh, there are also a few real stories like Voisey Bay where they found one of the biggest nickel mines in Canada in the last 50 years. Fun fact: it was discovered by a company named Diamond Fields… guess what they were looking for?

It is no different in new ventures in social media, technology of today. A real success story like Amazon keeps the dream alive – there is a real survivor bias while no one mentions all the companies that have failed.

The Claret Team